Pivotal Moments: Are Markets Forming A Bottom?
Ask Forstrong: Could global stock markets be bottoming here?
Bear markets are grinding affairs and wear down even the most patient investors.
Yet, contrary to today’s dire predictions, the conditions for a durable market bottoming process are here.
For investors with time horizons that extend beyond six months, risk should be steadily added on market dips.
The key is to recognize the unfolding market leadership change: an end to the dominance of growth and technology stocks, and a secular revival in tangible investment classes in the real economy.
“Aren’t you entertained?”, Elon Musk recently fired back at a journalist who questioned his serial tweeting and, often, reckless indulgence of the platform. But the billionaire’s quip could easily apply to today’s general state of world affairs: entertaining, yes, but also edgy, agitated and, even downright unpleasant. Toxic stories have led the headlines for so long that most of us no longer blink at the madness.
A quick survey of international news proves the point. The UK’s government is providing a masterclass in how not to do politics. Mark Zuckerberg’s pivot into the metaverse has been painful to watch — and has cost him dearly in the real world. Rivian, the high-profile and Amazon-backed electric truck company, just recalled all its vehicles due to a curious defect (“a loose nut”, the CEO said). And, as if Vladimir Putin’s game of global brinksmanship wasn’t enough, the inflation shock is now absorbing almost the entire conversational bandwidth in most countries.
Chaos is apparently the new world order. Coloring within the lines seems so last decade. And, at a moment in time that is increasingly unhinged, history has become an utterly useless guide — leaving investors desperately casting around for a stable forecast.
What on earth comes next? Our investment team has just concluded our 80th quarterly investment forum (yes, some of us have been doing this for a very long time and, yes, some years are more fun than others). As expected during this session, pencils were sharp and eyes were particularly wide open. It should now be abundantly clear that, rather than the last few years being an aberration, we are living through a profound shift in the trajectory of the global economy. And, it is a generational shift, on the same level as the rise of Keynesian policies after the second world war or the globalization that gathered pace in the early 2000s.
Inflationary Regime Changes Are Bumpy
At the core of this big shift lies inflation. Global prices are now rising at a double-digit pace for the first time in nearly four decades. Many did not see this coming. In fact, a strong consensus in the 2010s held the view that inflation and growth were permanently low for structural reasons. Poor demographics and productivity would keep growth sluggish, while globalization and digitization would keep inflation muted.
This has all been proved wrong. It turns out that the developed world can produce inflation after all. Yes, it took a pandemic to unleash extraordinary actions: bailouts, record stimulus, and a complete shut-down and re-opening of the entire global economy. But inflation has arrived, turbocharged by the war in Ukraine.
Yet inflationary impulses also have a longer-running support: a structural rise in government spending and investment. An aging population needs more healthcare services. The West needs to spend more on defense to counter threats from Russia and others. Climate change and the need for energy security will boost state investment in renewables. And heightened geopolitical tensions are leading policymakers to spend more on industrial policy.
On the surface, this outlook of high inflation may seem dire. At the same time, growth is slowing. The IMF forecasts the year ahead will face the lowest growth since 2001. Their chief economist, Pierre Olivier Gourinchas, piling onto the joie de vivre, predicts that 2023 will be the “darkest hour” for the global economy.
All very cheery stuff. And markets have taken note. Wealth destruction in 2022 has been eye-watering. Never mind the complete carnage in crypto (the last spasm of a speculative mania), the wipeout in SPACs (why did we allow profitless companies with no coherent business plans to come to market?) or even the wreckage in lockdown favorites like Netflix and Zoom. The declines this year in a plain-vanilla balanced portfolio have been record-setting: an equally split global stock and bond index has seen the largest ever loss in value, easily outdoing the declines of the 2008-2009 financial crisis and the 2020 pandemic.
Investor Sentiment: Can It Get Worse?
But financial conditions rarely remain in the same state for long. Market pendulums swing. And, of all the big ideas floating around — recession, deglobalization, energy shortages — none is quite as radical as the concept that markets may now be forming a durable bottom.
Why should we be discussing a new bull market when the outlook seems so bleak? The best answer is that levels of investor sentiment are now consistent with past bottoming processes. Markets do not form tops when investor sentiment is universally pessimistic. Rather tops occur with everyone predicting ever-sunnier skies ahead and partying like it’s 1999. Markets fully discount that view and upside surprises become much more difficult to deliver. By contrast, bull markets are born out of pessimism.
Today, we are facing a panic moment that, on many measures, is far worse than 2008’s global financial crisis. Consumer and business confidence has fallen by the most in a decade. Retail investors have driven record dollars into cash and short-term bonds. Even the pros have run for the hills, with average allocations to cash at the highest since 2001 and allocations to global stocks at an all-time low (hat tip to Bank of America’s fund manager survey).
With sentiment this pessimistic, upside surprises can come from several areas. China, the second largest economy in the world and a crucial driver of global growth, is a case in point. Covid suppression policies have caused severe damage to the most important segment of the Chinese economy: the middle-class consumer. Investors had been hopeful that restrictions would be lifted around the time of the Beijing Winter Olympics last February. Instead, Shanghai saw a brutal shutdown. Yet lockdowns will not last forever. Hong Kong has seen easing quarantine restrictions in recent weeks. To the extent that Hong Kong is a testing ground before trying new policies on the Mainland, this is encouraging. A re-opening China would be hugely bullish for markets and drive outperformance in cyclicals and commodity-exporting emerging market equities.
What about Europe, certainly the region of the world with the bleakest predictions? It would not be an outlandish forecast that they will muddle through the winter with a combination of coal-burning and energy rationing (and an overall relaxation of any ESG considerations). But looking across the valley, there is a larger trend at play here: the end of the fiscal austerity of the 2010s. Clearly, there is no policy appetite to return there. In fact, governments are under pressure to inject even more money into their economies to protect the public from the “cost of living” crisis. Germany’s recent €200bn “defence shield”, which provides support for gas importing companies, has extinguished once and for all any notion of fiscal restraint. Expansionary policies will drive growth higher over the coming years (even if fiscal conservatives will be holding their noses for a long time).
Yet of all the potential upside surprises, none is more crucial than the actions of the US Federal Reserve. Consider what is happening here. The Fed got the “inflation as transitory” view wrong and they are likely getting their policy wrong now too. To be fair, they have little choice. Restoring credibility is now their prime objective to correct for their earlier mistake. They cannot waver from a hawkish stance until evidence surfaces that inflation is coming down. That means they are hostage to incoming inflation data, operating without a forward-looking policy framework.
By contrast, investors are free to openly forecast the likely path of inflation. Here, evidence has surfaced that the Fed’s actions are working. Bond markets have brutally re-priced. Mortgage rates have doubled. In a matter of six months, financial conditions have quickly become the most restrictive in more than a decade.
Food, transportation, and housing account for 88% of the recent CPI. Each of these is showing decelerating price momentum. Commodities have corrected. Rental inflation is ultimately linked to the housing market. Falling home prices will lead to lower inflation there. Encouragingly, the dreaded wage-price spiral looks increasingly unlikely. All of this will pave the way for a declining trend in core inflation in the coming months and take pressure off the Fed. This is the foundation for maintaining a medium-term constructive view of markets.
Yet many will point out that market cycles did not bottom until central banks were deep into their easing cycles. This is true. The last two major bear markets (2000-2001 and 2008-2009) did not reach a bottom until interest rates reached their cyclical lows – when rates had reached sufficiently low levels to stabilize economic growth.
But the current market decline is clearly different from all the major bear markets since the late 1990s. The key difference is that those episodes occurred during a deflationary setting. Today’s bear is occurring in a strongly inflationary environment, which makes it more reminiscent of the 1973-1974 bear market. In inflationary climates likes these, bear markets are driven mainly by rising interest rates which cause a decline in equity multiples. The close negative correlation between rates and stock prices this year reinforces that view. But inflationary bear markets typically ends once price pressures peak and most of the monetary tightening has been priced into other asset classes. All of this suggests that the current bear market is at a very late stage.
Bear markets are brutal processes, involving many re-tests, gyrations, and false breakouts. This wears down even the most patient of investors. Living through it in real-time can be agonizing. But patience is always richly rewarded. Markets have already radically re-priced: yields are now higher and valuations are much lower. Expected portfolio returns should be ratcheted far higher from here.
Looking out to 2023, the macro backdrop will be completely different. By then, inflation, while still higher than the last decade, will be trending lower and central banks will be on hold. Markets will look past mild recessions. The key for investors is to recognize that major bear markets always signal a change in market leadership. The bursting of the global technology bubble is simply the first installment of a broader theme. Macroeconomic trends of the last decade have been punctured. The new combination of tighter monetary policy and looser fiscal policy means higher inflation and higher nominal growth.
The big investment opportunity is a secular revival in tangible investment classes in the real economy, ending the dominance of growth stocks. Investors will also need to look for exposures to sectors that are not reliant on low interest rates, but stand to benefit from higher public investment. Commodities and value stocks, with low valuations attached to them, are set for a long period of outperformance.
Whisper it, but a new bull market is quietly unfolding.